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Respect the Market

The market may not always be right, but does it matter?

There's an old saying among salespeople, "The customers may not always be right, but they're always the customers." It's meant to convey the importance of respecting the folks who control the cash. It doesn't matter if you're a Whirlpool(NYSE:WHR) representative trying to get a new style of washing machine into Lowe's(NYSE:LOW) appliance department, or a New York Life insurance agent trying to show a single mom the importance of having coverage to care for her children should she pass away unexpectedly. The message is still the same -- your customers are the ones who pay your bills by buying your products and services. Treat them right, because if they're not happy with what you're providing them, they can take their money elsewhere. If their money goes elsewhere, you simply don't eat.

Likewise, in investing, the market may not always be right, but it's always the market. Just as a sales rep must respect his or her customers in order to eat, as an investor, you must respect the stock market in order to get the profits you want out of it. An amazing $11 trillion worth of ordinary shares traded hands on the New York Stock Exchange last year. With nearly $10 trillion of common stock changing hands in the first nine months of this year already, that number looks destined to be easily surpassed. That's serious money. For perspective, that's significantly more than the U.S. government spent over the past three years, combined.

When dealing with scale like that, you must understand the rules of the game, a game set up for much larger investors. The $500 or $1,000 or even $10,000 you have to invest is quite significant to you. But when it's stacked up against giants like William Danoff, who runs the $50 billion Fidelity Contrafund(FUND:FCNTX) mutual fund, your money barely registers as a blip on the market's radar screen. No matter how much you would like the stocks you buy to rise as soon as you buy them, most of the time, your investment simply isn't enough to convince the market to move in your direction.

Ride the wavesUnlike most individuals, the big funds do move the market. As such, if you want to invest in that same market, you need to understand how their behavior affects the companies you're looking to own. The biggest funds act much like a Carnival cruise ship, cutting through an otherwise calm sea. In their wake, an otherwise calm and level stock may fluctuate wildly, running up and down as the funds buy and sell. And like the sea, stocks search for their own equilibrium. Sometimes they float above that level, sometimes they sink below. As an investor looking to buy low and sell high, you can take advantage of this volatility.

Watch out, however. While you certainly can take advantage of the fund-produced volatility, you simply cannot control it. Stocks' peaks can be pretty frothy, and their troughs pretty deep. Attempting to call the exact bottom or the exact top is a recipe for wiping out. To master the art of taking advantage of the rough waters left in the wake of the big investors, you need to keep your wits about you.

In essence, to profitably ride the waves left by the gigantic funds, what you need is a clear understanding of what a company is really worth, the fortitude to buy if it's below that level, and the willingness to sell if it's above that price. And believe me, it's easier said than done. Shortly after I bought analog semiconductor manufacturer Maxim Integrated Products(NASDAQ:MXIM), for example, its shares tumbled some 15% below my purchase price. They've since recovered, and my Maxim investment overall has kept pace with the market. As of this writing, it's actually edging out the S&P 500, in spite of having to overcome that substantial short-term fall. By focusing on what really counts -- a comparison of the company's stock market price to its true value -- I was able to avoid panic-selling at the bottom and see my investment recover.

Tools of the tradeIt's tough to see your investments lose money, even in the short term. Watching your portfolio balance drop, seeing your savings drip away . these things are never fun. But since you will rarely buy at the exact bottom or sell at the exact top, there will be times when your portfolio balance moves in the wrong direction. The best way to sit through the tough times is to compare what you own to what it's really worth. That way, if a falling price continues to drop, rather than focusing on what you've lost, you may be able to see an opportunity to scoop up more at a bargain. At minimum, you can at least use that information to convince yourself not to sell your $100 bills for $75.

At Motley Fool Inside Value, the tool we use to tell us what an enterprise is really worth is called a discounted cash flow calculator. Simply by plugging in a little bit of information about our companies and our expectations for their futures, the calculator can give us a rough estimate of what those firms are really worth as ongoing businesses. With that value number, we can make rational investing decisions, rather than let our emotions force us into buying too high or selling too low. If you're already a member, you can reach our calculator by clicking here. If not, then click here for a 30-day free trial and try it for yourself.

Using just such a calculator, Inside Value's lead analyst Philip Durell has put together a portfolio of companies that have handily outpaced the market for more than a year. Unfortunately for potential investors, some picks, like money market management firm Federated Investors(NYSE:FII), have so readily thrashed the market that they're no longer a bargain. Fortunately for potential investors, however, there are still a few, such as deep-discount retailer Dollar Tree(NASDAQ:DLTR), where the market's movements have left the company currently below even Philip's bargain-basement price.

The Foolish bottom lineThe market must be respected. While it's not always right, it's always the market. Much like the waves from a passing cruise ship, stocks' prices move both up and down in ways that are simply out of our control, although they do eventually seek a fair level. Learn to judge when a company's stock is below that fair level and when it's above, and you, too, can profit as a value investor.

Are you ready to respect the market enough to become excited and appreciative when it throws a sale on a company you want to own? Click here to start your risk-free trial to Inside Value and learn how to profit from others' panic.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of Lowe's and Maxim Integrated Products. The Fool has a disclosure policy.